Where a holding company is active (i.e. it is involved in managing its subsidiaries and makes management service charges to them), our approach as advisers has always been that the company is entitled to full VAT recovery on its costs of acquiring and managing those companies, including its overheads, because all the VAT incurred is a cost component of those taxable management services.
Similarly, where the holding company is a member of a fully taxable VAT group, the VAT incurred is a cost component of the taxable supplies made by the group. This is the case even if the holding company is passive, because by joining the VAT group it then becomes part of a single taxable person and the holding company costs are then linked to the taxable supplies made by the group, which will include the new corporate acquisitions. The recent Advocate General Opinion in the case of Commission v Ireland1 suggested that it is permissible to allow non-taxable persons to join VAT groups, although the issue remains ongoing.
Recently we have seen, however, that this approach to VAT recovery is being challenged by the UK, on the grounds that often a holding company will not recover all its costs from its subsidiaries and may use dividends received to make up any shortfall.
The UK tax authorities (HMRC) therefore argue that although the involvement in managing the subsidiaries for a fee is a business activity, it may not be a wholly economic activity – since dividends are not consideration for any supply – and hence some VAT must be disallowed. The situation is further confused by the UK’s tendency to classify non-economic activities as non-business, and not to distinguish between them, so the concept of a business but non-economic activity is relatively new and unknown. EU law on the other hand refers to economic, non-economic and private.
It is established case law2 that dividends should not be included in the denominator of the recovery calculation set out in Article 174 of the VAT Directive for goods and services used for both deductible and non deductible transactions.
Therefore, HMRC’s approach to limit the recovery of VAT on costs incurred by holding companies, merely because these costs are met out of dividend income, seems flawed, whether they are registered in their own right or as a member of a fully taxable VAT group.
It seems to have derived from linking cost component to sale price, so that VAT is disallowed if the costs are not ‘reasonably proportionate’ to the value of taxable supplies made. Nothing in VAT law limits the definition of cost component or its alternative expression of ‘a direct and immediate link to taxable supplies’ in this way. Indeed, there have been UK cases where a direct and immediate link to an exempt revenue stream has been established using methods completely remote from the sale price of those supplies, such as the mere mentioning of the relevant exempt activity in a footnote to an advert for taxable activities.
The UK courts have said “The quest is not for the closest link but merely for a sufficient link”. Although this is in the context of a link to exempt supplies rather than taxable, the same principles should surely apply in reverse?
Additionally, the approach of focusing on sale price alone to create that link, would, if taken to its logical extremes, see business VAT being disallowed, not just in holding companies, but in all companies that were not profitable or which needed any form of general subsidy (not linked to price) to continue trading, even if they made no exempt supplies. Clearly this is not how VAT recovery should work, as VAT itself should not be a cost of making taxable supplies. The overheads of a business have a direct and immediate link to, and are a cost component of, all its supplies.
Unfortunately, this latest challenge by the UK authorities has received a sympathetic hearing by the Upper Tribunal when examining overhead recovery of a hire-purchase business. The tribunal rejected HMRC’s submission that incorporation into sales price was how the cost component test was always to be determined. However, the tribunal nevertheless overturned the decision of the lower First Tier Tribunal, allowing recovery by the taxpayer – VWFS – as sought, as attributable to the activity of selling cars on finance. It also agreed with HMRC that the overheads of a hire-purchase business were not recoverable because the ‘economic reality’ of the situation was that VWFS was a financing business and thus the overhead expenditure should be attributed to the exempt business activity through which profits were driven. This flies in the face of common sense and of any proper analysis of the true economic use of the overhead VAT incurred. We strongly hope that this decision will be further appealed.
HMRC’s analysis does seem muddled. Although the Upper Tribunal refused to accept HMRC’s submission that sale price would always be the correct and only approach to the cost component test, meaning that perhaps our extreme examples above are too extreme, this simply replaces irrationality with uncertainty.
If our extreme examples are not a proper reflection of the new approach to cost component, then at what stage and in what circumstances does not passing on all its costs in its sales prices impact on a taxable business’s right to VAT recovery, and in what cases does it have no impact? Are there different rules for different businesses (holding companies v. trading companies) or at different stages of a business’s life? This cannot be right.
This may be a UK problem only, of course, but HMRC says its new approach is driven by EU case law, which is why we are drawing it to the attention of a wider audience.
1 Case C-85/11, European Commission v Ireland
2 Case C-142/99, Floridienne SA and Berginvest SA v Belgian State.